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Tuesday, December 25, 2012 - 10:00
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Tuesday, December 25, 2012 - 10:00

3 Types Of Explosive-Growth Companies -- And Why They're Dangerous

Tuesday, December 25, 2012 10:00 AM

Growth, for its own sake, has tripped up many companies -- and investors, for that matter.

Every year around this time, financial publications publish their list of America's fastest-growing companies. And their advertising departments love them. These are often the most popular issues of the year, as consumers try to find "the next Microsoft (Nasdaq: MSFT)" or "the next Google (Nasdaq: GOOG)."

Yet here's what these publications won't tell you as they're trying to drum up the media buzz: The fastest-growing companies are not often the best investments. In the pursuit of rapid growth, these companies resort to actions that are against the interest of shareholders.

Rapid growth isn't always a sure signal of a company's health. We've compiled a list of three types of high-growth companies you should avoid.

1. The money-raisers
Growth-oriented companies and Wall Street bankers are often locked in an unsavory dance. The bankers offer the promise of fresh cash to help these companies rapidly expand -- but with a catch that most investors overlook. Not only must these companies issue fresh stock to the bankers' clients in exchange for the money, which results in a dilution in the investment stake of existing shareholders, but these bankers also help themselves to another pair of investment perks that can dilute investors -- options and warrants.

Stock options are often granted to the underwriters of any stock offering, which can be converted into yet more shares if the stock price rises in the near-term (typically within a year). And warrants are also issued for the right to buy shares at a fixed price, which is often lower than the current market price. These warrants can stay out of view for several years until the underwriter suddenly re-emerges to claim his bounty.

(More on this: Options and warrants, which are basically contracts, operate in a similar manner, but are fundamentally different. While the company has the right to issue options, which can be had for free, the banker has the right to issue warrants, which have a price attached to them.)

If you are researching growth-oriented companies, you should focus your efforts on companies that already have ample cash on hand, generate positive cash flow from operations and can fund their growth with their own resources. Wall Street bankers tend to shun them, so you won't find them on Wall Street's buy lists, but there are ample resources on the Internet that allow you to screen for high-growth companies that are off the Wall Street radar. Once you've located them, see if the amount of shares outstanding has stayed fairly constant over the years.

2. The growth-for-its-own-sake crowd
Many young and growing companies are anxious to make it on to those "fast-growing" lists noted above. Very fast growth confers a degree of legitimacy, tacitly saying, "The marketplace loves our products." Yet the temptation is great to win new customers and new contracts at any cost. Companies rarely admit it, but major new customer wins often come at the expense of reasonable product pricing.

Look at the company's income statement. A company that can snag new business while holding firm to its price list will typically have flat or rising gross profit margins. Conversely, a company that is chasing growth and slashes prices to win business for its own sake invariably will see gross margins start to tumble. That's often the case when a company's product line has grown stale, and the only way to bag sales is to cut prices. That may be good for a company's top line but it's of little benefit to profit-focused investors.

3. The bloaters
On a related note, fast-growing companies often lose their lean demeanor, packing on hordes of middle managers to build a truly national organization. In some instances, a quickly growing company headcount means that expenses are growing even faster than sales, which will force down operating margins.

Action to Take --> The perfect growth stock is a company bringing in lots more revenue without a commensurate bulge in cost of goods sold or corporate overhead.

This article originally appeared on InvestingAnswers.com:
3 Types Of Explosive-Growth Companies -- And Why They're Dangerous

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.